Thinking about Equilibrium, Institutions and Governance

Mark Carney, Governor of The Bank of England, right, sits with Mario Draghi President of the European Bank, during The Bank of England's Open Forum Conference in London, Wednesday, Nov. 11, 2015. (AP Photo/Kirsty Wigglesworth)

Natura non facit saltum"Nature does not make a jump"— Epigraph to Alfred Marshall’s Principles of Economics

The notion that small changes should lead to small changes is a principle of economics and natural philosophy. And, yet, there are many instances in which economic variables do indeed leap from one equilibrium to another. Financial crises, for example, entail large, discontinuous changes in ‘flow’ variables — investment and output — even though the underlying ‘state’ variables describing the economy, such as the capital stock, are little changed. The problem for economics is that, while physical capital is the same after the crisis as before, the unemployment produced by the crisis entails a clear welfare loss that is inconsistent with Natura non facit saltum.

As Joe Stiglitz has argued [1], there are a number of explanations of the observed dynamics. For example, it is possible that state variables map into multiple equilibria rather than an unique outcome. Alternatively, expectations may be a state variable and subject to sudden sharp revisions. Another possibility is that there may be multiple long-run equilibria all consistent with a unique equilibrium, with the economy converging on a particular steady state depending on initial conditions. Small perturbations to initial conditions can lead to different long-run steady states. Inertia and hysteresis effects could also play a role: If individuals do not instantaneously and continually adjust behavior because of adjustment costs, so that behaviour adjusts only when the divergence between the optimal value of flow variables with and without adjustment costs grows sufficiently large, the result can be large discontinuous changes to flow variables.

All such explanations are consistent with rational expectations. The challenge for economic theory is to explain which of the equilibria is chosen by the economy. The rational expectations methodology of ruling out a priori all but unique stable equilibrium paths is one approach, but it is deeply unsatisfying since it is tantamount to imposing an equilibrium by assumption. It is equally possible, for example, that expectations are irrational or markets subject to ‘herding’ behavior. At the same time, finite-lived individuals, who cannot see infinitely far out into the future or assess the consequences of all possible states of the world, regardless of their perspicacity, are subject to ‘bounded’ rationality and cannot therefore rule out a priori paths that are ultimately unsustainable.

But whereas individuals are finitely lived, institutions broadly defined are, or can be, infinitely lived; well-functioning institutions can anchor expectations in the face of incomplete, asymmetric information and help the economy ‘pick’ the stable path. That is to say, effective institutions evolve endogenously to promote stable adjustment and more efficient resource allocation in the world we have, as opposed to the perfect foresight/rational expectations world of much of the economic modelling of the past quarter century, in which unstable paths are precluded a priori. Such ‘nudges’ may be as gentle as the governor of a key central bank suggesting that investors take seriously the possibility that oil reserves may become stranded and lose value if successful action is taken on addressing the climate change challenge.

Of course, not all institutions are well designed or equally effective. In this respect, as argued elsewhere, fundamental design flaws have contributed the anemic growth and episodic nature of debt crises within the Eurozone since the global financial crisis. While the architects of the euro may have viewed monetary union as the starting point for broad-ranging structural reforms that would transform a collection of disparate countries into an optimal currency area, the convergence of nominal magnitudes — illustrated by the rapid convergence of nominal interest rates on periphery member sovereign debt to German levels — was taken as the endpoint of the process. Moreover, the incomplete architecture of the Eurozone has fostered uncertainty and unstable expectations, rather than anchor expectations on a path consistent with a ‘good’ equilibrium.

While the ECB successfully stabilized financial markets with Mario Draghi’s commitment to “do whatever it takes” to preserve the euro, growth across the Eurozone has remained uneven and members with high debt-to-GDP ratios remain vulnerable to sudden shifts of expectations — from sustainable debt loads and low interest rates to fears of unsustainable debt loads and high interest rates that accompanies the perceived default risk. The situation remains fragile and some shock--the prospect of "Brexit" for example — could result in a renewed bout of volatility. In the meantime, the latest data reveal that deflation continues to haunt Europe.

Beyond the continuing travails of the Eurozone, the past several months have highlighted a number of challenges to the international community: Growth slowing in China and uncertainty about the Renminbi, the spread of negative interest rates, and the potential threat of beggar-thy-neighbour currency depreciation about whichBank of England Governor Mark Carney warned at the recent G-20 Meeting in Shanghai. But there is also opportunity: the successful outcome of the Paris Climate Change meeting in December gives hope that substantive progress can be made.

Thinking about equilibrium, institutions and governance, it seems clear that the remarkable progress that has been made towards reducing global poverty, as a billion people – three-quarters of them in China – emerged from extreme poverty, was made possible by the institutions that collectively form the web of governance.

Well before that, the institutions facilitated the orderly reconstruction and reintegration of Germany and Japan into the international community, avoiding the errors of Versailles. And in the interim, the governance arrangements facilitated the gradual, orderly reduction of tariff barriers that fostered efficient resource allocation and provided market access to newly-industrializing countries.

Most important, however, the institutions transformed the way that individual member states viewed the global economy. In the stagnation of the 1930s, countries viewed international exchange as a source of job loss as effective demand was siphoned off in import ‘leakages.’ This led to beggar-thy-neighbour policies of competitive exchange rate devaluation, tariff and non-tariff barriers and growing regionalism or currency areas, such as the Imperial Preference system under which the British Empire and her Commonwealth discriminated against non members. In the post-war period, that mindset of the global economy as a zero-sum game was replaced by an understanding that the global economy can be a positive-sum game, in which clear rules of the game and strong institutions provide benefits to all.

That felicitous outcome, fragile at the best of times, is today under pressure from huge adjustment challenges in the global economy and the need to preserve broad support for the governance arrangements among a more heterogeneous group of countries. With strong institutions of international cooperation to anchor expectations and guide policy choices, the global economy can remain a positive-sum game. Securing this goal will require that the international institutions are as effective as they can be; effective as they must be to address the challenges of the 21st century. The failure to rise to this challenge could mean a leap to another equilibrium, perhaps back to a zero-sum game view of the world economy and a fracturing of the global economy into regional or currency-based zones in which trade and financial frictions spillover to other domains.

[1] Joseph Stiglitz, Crises: Principles and Policies with an Application to the Eurozone Crisis.

With strong institutions of international cooperation to anchor expectations and guide policy choices, the global economy can remain a positive-sum game.

The opinions expressed in this article/multimedia are those of the author(s) and do not necessarily reflect the views of CIGI or its Board of Directors.

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